Tag: Regulatory

What is in a Name? Private Equity Industry Considers Label Change

Posted on by Kevin Badgley

Entering 2012, expectations were high for the private equity industry. Firms were finally recovering from the 2008 financial meltdown and private equity executives were confident that transactions would only continue to increase.[1] To top it off, one of the field’s very own had a legitimate chance to become our nation’s next president. Despite this favorable outlook, 2012 resulted in such damage to private equity’s image that some are now insisting the industry needs a complete rebranding.[2]

While the private equity industry has shouldered the blame for economic problems in the past, public criticism rose to unprecedented levels in the past year. The most widespread vilification occurred during the presidential election, when both Democrat and Republican rivals of candidate Mitt Romney spent millions attacking his private equity background.[3] Around the same time, a federal class action was filed accusing some of the nation’s largest private equity firms of a wide conspiracy to rig deal prices.[4] Considering the very negative popular conception of private equity following these events, it was not surprising when the Security and Exchange Commission’s enforcement division continued the assault by announcing that a regulatory heavy-hand would soon be coming down on the industry.[5]

Historically, private equity firms have not found this type of publicity overly concerning. They have had little need or incentive to uphold their image because they have operated completely in the private sector.[6] However, with many of the big firms going public in recent years, high-level private equity executives now believe that the industry must be “widely trusted” and maintain a “pristine reputation.” [7]

Looking to save face, some private equity practitioners have proposed rethinking the name “private equity.”[8] Blackstone Group President Tony James dislikes the label’s clandestine connotation and feels that it “subliminally sends the wrong message.”[9] Others argue for change by citing the fact that the industry is no longer truly “private,” as it is now regulated by government agencies.[10]

The corporate world has seen this type of makeover before. In the 1980s, “corporate raiders” became symbols of Wall Street greed for their tendency to conduct hostile takeovers of large companies. When legal countermeasures were put into place to thwart these attacks, corporate raiders revised their approach and adopted a more politically correct name: “activist shareholders.”[11] Since the re-characterization, activist shareholders have enjoyed success despite continuing to shake up companies like the corporate raiders before them.[12]

But still, in order for a name change to work, the industry must settle on an appropriate moniker. Noting how Blackstone provides its limited partners with widespread access to its portfolio companies’ financials, James suggests that the name should be changed to “clarity equity.”[13] Other ideas such as “ long term capital providers” and “opportunity capital” suggest positivity and communicate an actual function of these firms.[14]

While altering a label has helped groups repair their image in the past, it is a difficult process that is by no means guaranteed to succeed. An effective approach would supplement the name change with an effort to better educate the public on the benefits of the industry. Regardless of what these investors call themselves, their increasingly important reputation is unlikely to improve significantly unless they first make some attempt to eliminate the negativity surrounding the term “private equity.”

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[1] Hillary Canada, Survey Says: Glass-Half-Full Outlook For 1H 2012, Wall Street Journal Private Equity Beat (May 1, 2012, 7:08 PM), http://blogs.wsj.com/privateequity/2012/05/01/survey-says-glass-half-full-outlook-for-1h-2012/.

[2] William Alden, Rethinking the Term ‘Private Equity’, New York Times Dealbook (Jan. 31, 2013, 1:41 PM), http://dealbook.nytimes.com/2013/01/31/rethinking-the-term-private-equity/; Shasha Dai, Should Private Equity Industry Change Its Name?, Wall Street Journal Private Equity Beat (Feb. 1, 2013, 3:35 PM), http://blogs.wsj.com/privateequity/2013/02/01/should-private-equity-industry-change-its-name/.

[3] Tomio Geron, The Mitt Romney Effect on Private Equity and Venture Capital, Forbes (Sept. 21, 2012), http://www.forbes.com/sites/tomiogeron/2012/09/21/the-mitt-romney-effect-on-private-equity-and-venture-capital/.

[4] Don Jeffrey & Devin Banerjee, Blackstone, KKR, Bain, Accused of Agreeing Not to Compete, Bloomberg (Oct. 11, 2012), http://www.bloomberg.com/news/2012-10-10/investors-claim-kkr-told-equity-firms-not-to-bid-for-hca.html.

[5] See Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, Private Equity Enforcement Concerns at Private Equity International Conference (Jan. 23, 2013) (transcript available at http://www.sec.gov/news/speech/2013/spch012313bk.htm).

[6] D.M. Levine, Carlyle and Oaktree Are Latest Private Equity Firms Expected to Go Public, The Huffington Post (Apr. 11, 2012), http://www.huffingtonpost.com/2012/04/11/private-equity-firms-go-public_n_1417734.html public_n_1417734.html.

[7] Alden, supra note 2.

[8] Id.; Dai, supra note 2.

[9] Dai, supra note 2.

[10] See id.

[11] Bob Moon, Corporate Raiders Morph Into Nice(r) Guys, American Public Media Marketplace (Nov. 26, 2012), http://www.marketplace.org/topics/business/corporate-raiders-morph-nicer-guys.

[12] See id.

[13] Dai, supra note 2.

[14] See id.

SEC – Roadblock to Equity Crowdfunding?

Posted on by Katie Kincade

With such a promising name, what’s not for entrepreneurs, small businesses and venture capitalists to love about the Jumpstarting Our Business Startups Act (JOBS Act)?[1] Indeed, the Act was passed with bipartisan support in both houses and signed into legislation by President Obama on April 5, 2012. At its passage, the JOBS Act was widely proclaimed as a promise for growth for small businesses and start-ups because of the Act’s capacity to increase access to capital.[2] Despite this initial phase of promise, the JOBS Act has gotten off to a rather slow start in the realm of equity-crowdfunding.

One of the ways in which the Act is designed to help startups is by making it easier to obtain additional capital through equity crowdfunding. Although it has been a buzzword for the last few years, crowdfunding is not a new phenomenon. Traditional crowdfunding is defined as “the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.”[3] In the United States, the Securities Act of 1933[4] and the Securities Exchange Act[5] restrict the potential means of generating funds via crowdfunding. These Acts prohibit entities from offering or selling securities to the public unless the offering is registered with the SEC, or unless there is an exemption from registration. Thus, the SEC registration requirements have limited crowdfunding to a means of generating capital from contributors without the prospect of financial return on investment (i.e., no equity offerings for funders). Accordingly, crowdfunding enterprises solicit funds by means such as offering prizes for donations or by offering funders the option to purchase a product prior to the product’s release on the market.[6] But even with the availability of numerous crowdfunding platforms[7] to incentivize offerings, many enterprises currently find it difficult to access substantial capital using traditional means of crowdfunding.

Equity crowdfunding in the United States, however, would enable enterprises to issue equity in return for crowdfunders’ contributions. The prospect of return on investment would entice many would-be-funders to take the financial leap-of-faith and support startups. Equity crowdfunding can also be particularly useful to small-business owners who have been unable to secure adequate funding through more traditional means like small business loans. To date, many foreign countries, particularly member states of the European Union and Hong Kong, have already capitalized on the potential of crowdfunding by permitting startups to issue equity to investors.[8]

The JOBS Act recognizes the potential for equity crowdfunding and amends the provisions of the Securities Act of 1933 and the Securities Exchange Act that foreclose the opportunity to crowdfund due to SEC registration requirements.[9] The “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,”[10] in particular, addresses the conflict by creating an exemption for unregistered securities offered by private companies via the “crowdfunding exemption”[11].

But still, further government action is necessary before the crowdfunding exemption can go into effect. In an effort to protect investors from the potential of fraud that equity crowdfunding entails, the Act requires the SEC to issue rules governing the crowdfunding provisions.[12] The Act provides a period of 270 days from the date of enactment[13] in which the SEC is to issue these rules. On December 31, 2012, this 270-day period expired without any such rules having been announced.

Although it has been nearly a year since the legislation was enacted and three months since the expiration of the deadline, there is no indication the rules will be issued any time soon. Factors that may be contributing to this delay include a rulemaking-backlog (created largely from the 2010 Dodd-Act mandates) and a still-pending change in chairmanship at the SEC.

So when can we expect equity-crowdfunding to go into effect? It depends on whom you ask, but the prognosis generally is not good. Many fear it will not be any time soon,[14] while others claim at earliest next year.[15] Even worse, some believe that even if the SEC does issue rules, the rules may be so complicated as to preclude the opportunity to equity crowdfund in practice.[16]

In the meantime, small businesses and would-be entrepreneurs are feeling the hit. But they are hardly waiting idly by. Crowdfunding organizations are seeking the media’s attention through venues such as the National Press Club in Washington DC, as well as speaking with the SEC directly to inform the Commission of the industry’s current investor protection mechanisms.[17] Members of the Crowdfunding Professional Association, for example, have already met with the SEC more than thirty times.[18] Despite the industry’s efforts to push-start the crowdfunding exemption into action, the wait continues. If and when the SEC finally issues the rules, the crowdfunding exemption has enormous potential to help small businesses.

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[1] Jumpstart Our Business Startups Act (JOBS Act), Pub. L. No. 112-106 (2012).

[2] See, e.g., JOBS Act Promises to Improve Access to Capital, Husch Blackwell (Apr. 5, 2012), http://www.huschblackwell.com/jobs-act-promises-to-improve-access-to-capital/.

[3] Tanya Prive, What Is Crowdfunding and How Does it Benefit the Economy? Forbes (Nov. 27, 2012, 10:50AM) http://www.forbes.com/sites/tanyaprive/2012/10/12/top-10-benefits-of-crowdfunding-2/.

[4] Securities Act of 1933 §5, 15 U.S.C. §77e (2006).

[5] Securities Exchange Act 15 U.S.C. §78d.

[6] See generally Thaya Brook Knight et. al., A Very Quiet Revolution: A Primer on Securities Crowdfunding and Title III of the JOBS Act, 2 Mich. J. Private Equity & Venture Captial L. 135, 135-36 (describing four current methods of crowdfunding in the United States).

[7] See generally Devin Thorpe, Eight Crowdfunding Sites for Social Entrepreneurs, Forbes, http://www.forbes.com/sites/devinthorpe/2012/09/10/eight-crowdfunding-sites-for-social-entrepreneurs/ (providing an overview of top crowdfunding platforms).

[8] Ralf Hooijschuur, Crowdfunding in Different Countries – Legal or Not? Squidoo http://www.squidoo.com/crowdfunding-in-different-countries2 (last visited Mar. 18, 2013).

[9] Securities Exchange Act 15 U.S.C. §78d.

[10] JOBS Act, Pub. L. No. 112-106 §301 “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.”

[11] Id. at §302

[12] Id.

[13] Id.

[14] See, e.g., Destiny Bennett, SEC Stalls in Setting Rules for Crowdfunding, AGBeat (Feb. 21, 2013), http://agbeat.com/finance/sec-continues-stalling-in-setting-rules-for-crowdfunding/.

[15] Kathleen Pender, Crowdfunding Awaits Key Rules from SEC, SFGate (Feb. 8, 2013, 6:58PM), http://www.sfgate.com/business/networth/article/Crowdfunding-awaits-key-rules-from-SEC-4264631.php

[16] Marco Santana, Entrepreneurs Await Rules for Crowd-Funding Clause, USA Today (Jan. 20, 2013, 10:03PM), http://www.usatoday.com/story/money/business/2013/01/20/crowd-funding-clause-startups/1566496/ (worrying that the rules the SEC ultimately provides will render the crowdfunding clause impracticable.).

[17] Catherine Clifford, Crowdfunders Step Up Lobbying for SEC Rules, Entrepreneur (Feb. 19, 2013), http://www.entrepreneur.com/article/225863.

[18] Id.

Private Equity Firms Accused of Misleading Buyer

Posted on by Kevin Badgley

Japanese beer and beverage maker Asahi Group has filed a lawsuit in Australia against two private equity firms who sold Asahi a liquor company for $1.3 billion USD. The suit claims that Australian-based Pacific Equity Partners and Hong Kong-based Unitas Capital—the previous owners of New Zealand’s Independent Liquor—presented inflated earnings figures during the sales process.[1] As a result of this “misleading and deceptive conduct,” Asahi feels that it grossly overpaid for the premixed cocktail distributor and that it deserves compensation.[2]

At the heart of Asahi’s complaint is the allegation that Independent Liquor’s earnings before interest, tax, depreciation, and amortization (EBITDA) figures were embellished.[3] EBITDA is often used to value a company for purposes of buying it, and has been called the “single most important financial contributor to buyout performance.”[4] The complaint alleges that Independent used creative accounting techniques such as ‘channel stuffing’—“a practice where a supplier forward sells stock on extended terms to retailers in order to account for significant ‘one off’ sales in a particular period”—to wrongfully include income and exclude expenses.[5] Asahi claims that these practices inflated Independent’s EBITDA by $NZ42 million,[6] and made it appear as if Independent was growing at the time of the sale when normalized calculations show that it was actually declining.[7] These inconsistencies likely had a significant impact on the negotiated purchase price, as Asahi claims it “conducted due diligence thoroughly and in good faith and relied on [the EBITDA figures] provided.”[8]

Although this dispute will be resolved in an Australian court, it is factually similar to a case arising out of Delaware a few years ago. In ABRY Partners v. Providence Equity,[9] the buyer, ABRY Partners, accused the private equity seller, Providence Equity Partners, of knowingly presenting a portfolio company’s misstated financials in connection with a sale.[10] The purchase agreement contained provisions designed to insulate Providence from liability for representations made by its portfolio company.[11] Specifically, the warranty that ABRY claimed was breached was “by its plain terms . . . [a warranty] made only by the [portfolio company] and not by [Providence].”[12] The agreement also contained a $20 million indemnification cap.[13] The Delaware Court of Chancery ultimately found that the indemnification cap would be honored if Providence did not lie.[14] However, it found that ABRY could collect damages in excess of the cap if it could prove that Providence knew its portfolio company made false representations or if Providence itself made such representations.[15]

If the Australian court takes a similar approach, the purchase agreement will be crucial in determining the level of culpability Asahi must prove and the amount of damages that they can recover. ABRY suggests that a properly drafted agreement can insulate PE firms from fraud committed by their portfolio companies in connection with the sale as long as the firm was not aware of it. If such a term were contained in this agreement, it would force Asahi to prove that these companies knew Independent was manipulating the EBITDA figures. While this is a seemingly heavy burden, the Asahi complaint suggests that they would be able to prove knowledge through email correspondence they have obtained.

Regardless of the outcome, this case evidences the importance of (1) conducting thorough due diligence; (2) understanding ways in which EBITDA can be manipulated; and (3) thinking carefully about future liability when drafting purchase agreements.

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[1] Neil Gough, Asahi Sues 2 Private Equity Firms Over $1.3 Billion Deal, N.Y. Times (Feb. 14, 2013, 5:13 AM), http://dealbook.nytimes.com/2013/02/14/asahi-sues-2-private-equity-firms-over-1-3-billion-deal/.

[2] Id.

[3] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, The New Zealand Herald (Feb. 18, 2013, 11:45 AM), http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10866101.

[4] Nicolaus Loos, Value Creation in Leveraged Buyouts 229 (2006).

[5] Adele Ferguson, Japanese Brewer Up in Arms Over Purchase Price, Newcastle Herald (Feb. 26, 2013, 5:00 AM), http://www.theherald.com.au/story/1326151/japanese-brewer-up-in-arms-over-purchase-price/?cs=9.

[6] See id.

[7] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, supra note 3.

[8] Gough, supra note 1.

[9] ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006).

[10] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, Goodwin Proctor LLP (Mar. 14, 2006), http://www.goodwinprocter.com/~/media/Files/Publications/Newsletters/Private%20Equity%20Update/2006/Ruling_in_ABRY_Partners_v_Providence_Equity_Case_Has_Lessons_for_Buyers_and_Sellers.pdf.

[11] See id.

[12] ABRY Partners, 891 A.2d at 1042.

[13] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, supra note 10.

[14] See id.

[15] See id.

Delaware Court Gives New Meaning to the Non-Disclosure Agreement

Posted on by Tristan Heinrich

“But the road to true love seldom runs smooth, even for companies that make paving materials.” [1] This was just one of the memorable remarks from a recent Delaware Chancery Court decision, where Chancellor Leo Strine added a new twist to the way the court construes language in Non-Disclosure Agreements (“NDAs”). The opinion provides a plethora of information about NDAs and reminds law students – who may draft and negotiate these documents during their first years at a firm –that NDAs have significant strategic implications for clients and that standardized terms in these documents could be costly. Strine, in a lengthy opinion, strictly construed language in an NDA to have the effect of a standstill provision and issued an equitable remedy for the breach of the contract.[2]

This dispute began when Martin Marietta, a North Carolina aggregates corporation, entered into friendly discussions with Vulcan Materials (“Vulcan”), a large domestic aggregates corporation headquartered in Alabama.[3] Pursuant to the NDA facilitating these discussions, Martin Marietta could only use information acquired during the discussions for the purpose of considering a “business combination transaction” that was “between” the parties.[4] After discussions broke down, Martin Marietta used information it gained during the friendly talks in SEC public disclosure documents, investor calls, and press releases while it launched an unsolicited exchange offer proposing a deal of .5 shares of Martin Marietta for each Vulcan share.[5] Vulcan argued that the language in the NDA meant that any information gained from either side during the initial discussions was limited to use in “a friendly, contractual business combination between the two companies that was negotiated between the existing boards of the two companies, and that was not the product of a proxy contest or other unsolicited pressure strategy.”[6] Martin Marietta argued that the NDA allowed either side to use the information from the friendly negotiations for any type of business combination transaction between the two companies, and that Vulcan was attempting to read a standstill into the agreement even though it did not contain an explicit standstill.[7]

Strine looked to extrinsic evidence to resolve ambiguity in the contract language, focusing on Martin Marietta’s position as a potential target in the merger at the time of the NDA, and their sloppy attempts to gather and silo material gained during the friendly discussions in an effort to claim that information was not used in the hostile bid.[8] Martin Marietta’s changes to the initial NDA were “unidirectional: every one of the proposed…changes had the effect of making the NDA stronger in the sense of broadening the information subject to its restrictions and limiting the permissible uses and disclosures of the covered information.” According to Martin Marietta CEO Ward Nye’s own notes, at the time of the NDA he and his team were “interested in discussing…the prospect of a merger, but not an acquisition whether by [Vulcan] or otherwise.”[9] However, information gathered during discussions led Nye to believe there was an additional $100M each year in synergy potential above his initial estimates.[10] Nye claimed that the team evaluating the deal did not rely on any non-public information, but Strine held that once Nye had this information the deal was tainted. Any evaluation of a hostile bid at that point was an unauthentic attempt at using public information to rationalize synergy estimates derived initially from non-public information.[11]

Finally, the parties had included a clause in the NDA providing for injunctive relief in the event of breach by either side, and Strine held that “[t]he very fact that measuring the precise loss to Vulcan in terms of negotiating leverage, customer relations, and productivity loss from Martin Marietta’s misconduct is difficult to impossible is a reason why the parties’ voluntary agreement that any breach would give rise to injunctive relief should be respected and honored, not gutted by a judge, particularly of a state whose public policy is pro-contractarian.”[12] The injunction reflected the timing spelled out in the NDA restrictions and prevented Martin Marietta from making a hostile bid for four months.[13] While news reports have suggested that a renewed bid for Vulcan is on the table again because the injunction expired on September 15, 2012, the injunction has the practical effect of preventing a hostile bid for much longer.[14] The four month injunction prevented Martin Marietta from running its slate of directors at Vulcan’s June 1, 2012 annual meeting, and since only two Vulcan directors are up for election in 2013, the ruling eliminates Martin Marietta’s chances of taking control of Vulcan’s 10-member board until 2014.[15] Additionally, Vulcan’s position has now strengthened and analysts estimate that Martin Marietta would have to offer .7 shares for every share of Vulcan, a costly 40% increase above the previous bid.

Here are just a few takeaways from this decision:

You may not know your client is the target until it is too late

Vulcan entered into the initial NDA thinking it was the potential acquirer, and Martin Marietta ended up using information to turn Vulcan into the target. NDAs have the potential to enable or limit future strategic opportunities for clients, so they should not be viewed just as preliminary agreements that can be entered into without consequence.[16] The client’s position may shift based on information uncovered during friendly discussions and the thinking behind the language in the NDA should contemplate a range of potential outcomes.[17]

Establish a clean team to preserve a hostile takeover bid

Strine suggested that establishing a “clean team” may be a sufficient way to keep open the possibility of a hostile bid after friendly discussions are not fruitful.[18] Sequestering internal personnel, directors and advisors from exposure to confidential information could keep this option open, although in many cases this will not be available because senior executives need to be involved in both potential friendly negotiations as well as any potential hostile bid decisions.[19]

Do not count on a strict construction of the NDA – include a formal standstill to avoid a hostile bid

It is left for us to guess why Vulcan and Martin Marietta did not have a standstill agreement in their NDA. The most plausible reason is that neither party contemplated a hostile takeover bid. Something as simple as a friendship between executives may be a reason that parties do not include standstills in early conversations. But it’s better to be safe than sorry. Friendly relationships can easily sour during negotiations and clients concerned about a potential takeover bid would be wise to include a standstill provision. While a standstill provision may be a contentious issue, negotiating the types of information and the length of time applicable to any restrictive clauses may be a way to provide both sides what they need to fully engage in friendly discussions.[20] Additionally, the process of negotiating these items may uncover whether the other party wants to keep the hostile option on the table.

Do not forget about Injunctive relief

Delaware law allows parties to stipulate elements of a compulsory remedy.[21] While the injunctive relief in this case mirrored the initial timelines set in the NDA on restrictive use of information, there is no guarantee that the court will stick to timelines provided in the NDA when it comes to injunctive relief. Chancellor Strine noted that Vulcan’s request for relief was for the minimum period, and that a longer injunction may have been justified by the pervasiveness of the breaches.[22] It is plausible that the court in future cases could extend injunctive relief for up to a year beyond the NDA timing for the purpose of preventing a party from running directors at an annual meeting, which could then have longer-term implications for gaining board control depending on the timing of board elections.

Think early and often about framing the executive storyline

Strine staged the legal analysis with an extensive account of the facts and particular emphasis on Ward Nye, Martin Marietta’s CEO. Strine noted that “Nye was not at all anxious to find his chance to be a CEO lost in a large synergistic merger, which was a possibility depending on the relative negotiating and financial strength of Vulcan and Martin Marietta in merger talks.”[23] He also noted that “Nye’s own desire to be CEO and to have the headquarters in Raleigh was simply a selfless manifestation of his and Lloyd’s obviously superior management approach and the undisputed fact that an aggregates company should be closer to ACC basketball than SEC football.”[24] Further, Strine wrote “Nye did not want to be demoted, even during a transition period, and evinced a willingness to forego a 20% premium for Martin Marietta stockholders in the exchange ratio to ensure he was slotted as CEO right away.”[25] As if that were not enough, Strine added in a footnote that “[t]he Chinese concept of face is a good one for effective negotiators and public figures to keep in mind. Nye and Lloyd [Martin Marietta’s CFO] seemed to have had the same grasp of that concept as the self-engraved chosen one.”[26] While Strine’s legal analysis regarding ambiguity focused on the circumstances leading to the NDA, we can wonder to what extent the court’s image of Nye may have played a role behind the scenes.

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[1] Martin Marietta Materials, Inc. v. Vulcan Materials Co., 2012 WL 5257252, at *15 (Del. Ch. May 4, 2012) aff’d, 45 A.3d 148 (Del. 2012) and aff’d, 254, 2012, 2012 WL 2783101 (Del. July 10, 2012), as corrected (July 12, 2012).

[2] Jonathan M. Grandon & Christina Bergeron, New Guidance on Confidentiality Agreements, 4 Fin. Fraud L. Rep. 607, 609 (2012). A traditional standstill provision expressly prohibits a party from pursuing any alternative acquisition of its securities or attempting to exert any control over its management or board of directors for a set time period.

Jahangier Sharifi, et al., The Accidental Standstill, Richards Kibbe & Orbe LLP (July 20, 2012), http://www.rkollp.com/assets/attachments/The%20Accidental%20Standstill.pdf.

[3] Martin Marietta Materials, Inc., 2012 WL 5257252 at 1-2.

[4] Id, at 3.

[5] Id, at 3, 25.

[6] Id, at 3.

[7] Id, at 4.

[8] Martin Marietta Materials, Inc., 2012 WL 5257252 at 36-37.

[9] Id, at 37.

[10] Id, at 14.

[11] Id, at 19.

[12] Id, at 58.

[13] Martin Marietta Materials, Inc., 2012 WL 5257252 at 58.

[14] Tara Lachapelle & Thomas Black, Martin Marietta Seen Bumping Vulcan Bid: Real M&A, Businessweek (Sept. 18, 2012), http://www.businessweek.com/news/2012-09-18/martin-marietta-seen-bumping-vulcan-bid-real-m-and-a.

[15] Martin Marietta Materials, Inc., 2012 WL 5257252 at *58; Fraud Report 609.

[16] Marc Kushner & Medard T. Fischer, Corporate E-Review: Strategic Lessons Arising From Canadian and U.S. Judicial Consideration of Confidentiality Agreements, JDsupra.com (October 17, 2012), http://www.jdsupra.com/legalnews/corporate-e-review-strategic-lessons-ar-71002/.

[17] Jonathan M. Grandon & Christina Bergeron, New Guidance on Confidentiality Agreements, 4 Fin. Fraud L. Rep. 607, 612 (2012).

[18] Martin Marietta Materials, Inc., 2012 WL 5257252 at *17

[19] Marc Kushner & Medard T. Fischer, Corporate E-Review: Strategic Lessons Arising From Canadian and U.S. Judicial Consideration of Confidentiality Agreements, JDsupra.com (October 17, 2012), http://www.jdsupra.com/legalnews/corporate-e-review-strategic-lessons-ar-71002/.

[20] Id.

[21] Jonathan M. Grandon & Christina Bergeron, New Guidance on Confidentiality Agreements, 4 Fin. Fraud L. Rep. 607, 611 (2012).

[22] Martin Marietta Materials, Inc., 2012 WL 5257252 at *59

[23] Id. at *5

[24] Id. at *17

[25] Id.

[26] Id. at *17 n.80

Private Equity Shares the Spotlight with Tax Reform

Posted on by Stephanie Cunningham

Post-2012 Presidential Election, the private equity industry is in the public spotlight simultaneously with the tax reform proposals. Throughout the election, private equity was a constant topic of conversation – especially Bain Capital. Acknowledging the media attention received from the election, Bain Capital addressed its investors in a formal letter thanking them for their support despite the increased scrutiny.[1] In this letter, Bain Capital attempted to portray the positive aspects of the business outside of its profits by asserting its creation of hundreds of thousands of jobs and support of hundreds of charities in its 28-year history. [2] These reassurances acknowledge the added scrutiny to the private equity industry that may not disappear post-election.

Tax reform is one topic that has emerged in response to the perceived inequities in the tax code and the need to reduce the national deficit. Earlier this year, President Obama proposed changes to the tax code to end corporate tax breaks and decrease the corporate tax rate from 35% to 28%. [3] Similarly, the top House Republican tax writer, Dave Camp, has vowed to pass tax reform legislation in 2013.[4]

With the private equity industry comprising a significant amount of the U.S.’s economic activity, this industry is not likely to avoid the effects of tax reform. Venture capital, one subset of private equity, alone provides 21% of the U.S. GDP.[5] If these efforts to close the gaps in the tax code are successful, private equity’s increased media attention comes at an inopportune time in light of the industry’s favorable “carried interest” rates.

Under the “carried interest” rule, private equity firms, alongside real estate and mining partnership structures, could lose its favorable tax treatment. In this provision, private equity firms are able to pay the capital gains tax rate, 15%, on a third of its profits rather than the income tax rate, 35%, paid on the remaining two-thirds of payments made on the guaranteed annual management fees. [6] Supporters of the favorable tax treatment argue that the private equity firms should be viewed as entrepreneurs whose risk-taking should be encouraged by this favorable tax rate.[7] Yet, some critics of the favorable tax rate state argue that private equity funds should be treated like investment bankers who use individual investor funds in these risky investments and retain approximately a 2% management fee and a 20% profit if they reach their target.[8]

Congress estimates that eliminating this favorable tax rate could generate up to $2 billion in tax revenues, increasing the attraction to close this provision. [9] Despite objections from the industry that investors would not receive adequate returns on their investments in this risky industry, there are admissions of some industry members that the “carried interest” provisions are generous.[10]

As the public and Congress continue to look more closely into the private equity industry, the favorable tax provision in private equity will not likely avoid review following the election. Consequently, as the support for tax reforms increases in the upcoming year, the media attention provided to the private equity industry makes the industry a prime candidate for tax reform in 2013, decreasing or eliminating the “carried interest provision”.

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[1] Greg Roumeliotis, Bruised by Romney criticism, Bain Capital thanks investors, Reuters (Nov. 8, 2012, 8:31PM), http://www.reuters.com/article/2012/11/09/us-usa-campaign-bain-idUSBRE8A804220121109.

[2] Id.

[3] See, Kevin Drawbaugh & Patrick Temple-West, Top U.S. House tax writer vows tax reform in 2013, Reuters (Nov. 15, 2012, 8:26 PM), http://www.reuters.com/article/2012/11/16/us-usa-tax-camp-idUSBRE8AF00620121116; Zachary A. Goldfarb, Obama proposes lowering corporate tax rate to 28 percent, The Wash. Post (Feb. 22, 2012), http://www.washingtonpost.com/business/economy/obama-to-propose-lowering-corporate-tax-rate-to-28-percent/2012/02/22/gIQA1sjdSR_story.html.

[4] Id.

[5] Brian McCann, Private Equity Searches for its Public Identity After the US Election, Opalesque (Nov. 15, 2012), http://www.opalesque.com/private-equity-strategies/2/private-equity-searches-for-identity-after-the.html .

[6] An end to the carry on, Buy-out firms face the prospect of a bigger tax bill, The Economist (Nov. 17, 2012), available at http://www.economist.com/news/finance-and-economics/21566647-buy-out-firms-face-prospect-bigger-tax-bill-end-carry.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

Should the Carried Interest Tax Loophole be Eliminated?

Posted on by Miguel Oria

With the “fiscal cliff”[1] fast approaching and the federal budget taking center stage in national politics, legislators are under intense pressure to find politically feasible changes to the tax code that can be used to raise revenue. One feature of the tax code in particular – its treatment of the “carried interest” income earned by most private equity and hedge fund managers – has fallen squarely within these legislators’ crosshairs. It seems likely that this “loophole” will soon be eliminated, but current proposals for doing so miss the mark.

Most private equity firms’ fees are structured on the “2 and 20” model. The “2” refers to a baseline fee fixed at 2% of assets under management, which is taxed as ordinary income. The “20,” on the other hand, is the famous “carried interest:” fund managers also keep 20% of all gains realized by the fund. Because private equity funds typically enter relatively long-term investments, private equity fund managers can characterize their carried-interest income as long-term capital gains, which are taxed at 15%.[2] Thus, successful private equity fund managers – whose incomes routinely exceed seven figures – often have the bulk of their income taxed at the low rate of 15%.

Not surprisingly, this practice has drawn scrutiny from legislators in Washington. Congressman Sandler Levin has introduced a “Carried Interest Fairness Act” in the House of Representatives,[3] and President Obama’s 2013 budget specifically targets the loophole.[4] Both simply propose that carried interest be taxed as ordinary income. This is an enticing solution: it singles out these wealthy fund managers, a group many people find unsympathetic,[5] and it raises much-needed revenue.

However, resolving this issue may not be quite so simple. Whatever justifications exist for taxing other kinds of capital gains at rates lower than ordinary income may apply for carried interest income as well. For example, some argue that lowering capital gains taxes incentivizes risk-taking and investment; these incentives are certainly in play in the private equity world. The same is true of the “lock-in” rationale: some say lowering capital gains taxes prevents people from holding on to subpar investments simply for tax purposes, and the same considerations could affect the decision-making process of private equity fund managers deciding when to realize their gains.

A simpler solution would be to eliminate the distinction between capital gains and ordinary income altogether. Economic research has found little, if any, empirical evidence supporting the rationales described above.[6] More direct and effective methods can be used to achieve the purported benefits of low capital gains tax. Worst of all, this distinction encourages people to engage in inefficient rent-seeking. The time spent by accountants and tax lawyers thinking of ways to re-characterize income, and indeed the hours spent writing this very article, could be used for other pursuits. The most sensible solution, then, is to do away with this distinction and tax income of all types at one simple rate.

_______________________________________________
[1] I.e., the large number of scheduled tax increases and spending cuts set to go into effect in early 2013. See Jonathan Weisman, Q&A: Understanding the Fiscal Cliff, N.Y. Times Economix Blog (Oct. 9, 2012, 6:28 PM), http://economix.blogs.nytimes.com/2012/10/09/qa-understanding-the-fiscal-cliff/.

[2] Janet Novack, Romney’s Taxes: It’s the Carried Interest, Stupid, Forbes (Aug. 24, 2012, 6:03 PM), http://www.forbes.com/sites/janetnovack/2012/08/24/romneys-taxes-its-the-carried-interest-stupid/.

[3] H.R. 4016, 112th Cong. (2012).

[4] Cutting Waste, Reducing The Deficit, And Asking All To Pay Their Fair Share (2012), available at http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/cutting.pdf.

[5] (just ask Mitt Romney)

[6] See, e.g., Capital Gains and Dividends: What is the effect of a lower tax rate?, Tax Policy Center, available at http://www.taxpolicycenter.org/briefing-book/key-elements/capital-gains/lower-rate.cfm; Brendan Greeley, Study Finds Benefit is Elusive for Low Capital Gains Rate, Bloomberg (Oct. 4, 2012, 10:17 AM), http://www.bloomberg.com/news/2012-10-04/study-finds-benefit-is-elusive-for-low-capital-gains-rate.html

London Bank Scandals Open Doors for Financial Start-Ups

Posted on by Zachary A. Ciullo

Throughout the United Kingdom, consumers’ trust in banks has deteriorated due to a series of recent scandals.[1] The tidal wave started in June, 2012, when Barclays Bank agreed to pay $450 million to settle claims that it manipulated interest rates to lift profits and mask concerns about its declining health.[2] Next, the United States Senate issued a report that HSBC bank failed to stop laundering Mexican drug money; HSBC faces up to $1 billion in fines.[3] Furthermore, JPMorgan & Chase Co. recently disclosed a $5.8 billion trading loss caused by its London office in a portfolio designed to circumvent risks that the bank takes with its own money.[4] As a result to these financial disasters, London bankers now worry that regulators will increase their efforts to clean up the image of the financial sector and quell public outrage.[5]

As a result of these scandals, newcomer financial firms seek to capitalize on United Kingdom banks’ misfortunes. Financial startups are using new technology and are innovating in ways that banks cannot in order to improve customer service, and venture capital firms are jumping at the chance to get a piece of the action.[6] For instance, Wonga, an online lending firm that offers high interest lending services to small businesses and consumers, has secured about $150 million in venture investment[7] from Balderton Capital, TAG, and Kreos Capital.[8] To cut own on costs, Wonga gathers publically available online data to determine a potential lendee’s creditworthiness.[9] Consumers are attracted to the fact that they can obtain loans within 15 minutes that they would not be able to receive from banks due to their risky credit.[10] Last year, Wonga reported revenues amounting to $73 million,[11] and is contemplating a $1.5 billion IPO on Nasdaq.[12]

Other venture capital success stories include GoCardless, a new financial firm based in London, which provides services to small businesses and consumers, allowing them to set up monthly payments directly to suppliers, at a cost dwarfing that of what banks charge.[13] The company is able to provide such favorable rates by cutting out the cost and complexity of credit card networks.[14] GoCardless has secured approximately $1.5 million from the venture capital firm Y Combinator.[15]

Finally, as banks have pulled back on lending, deeming small businesses to be too much of a financial risk, MarketInvoice helps small businesses obtain capital fast.[16] MarketInvoice is an online marketplace where small businesses are able to auction their long-term supply contracts to money managers for the highest price.[17] The company has received $1.4 million from venture capital investors.[18]

Growing disdain among small businesses and consumers for banks in light of recent scandals in conjunction with new innovative and technological services provided by financial start-ups has sparked a new industry in the United Kingdom. Venture capital firms will without a doubt continue to seize on the opportunity to invest in these financial start-ups.

____________________________

[1] Mark Scott, In London, Nimble Start-Ups Offer Alternatives to Stodgy Banks, N.Y. Times DealBook (Oct. 22, 2012, 4:45 PM), http://dealbook.nytimes.com/2012/10/22/in-london-nimble-start-ups-offer-alternatives-to-stodgy-banks/.

[2] Ben Protess & Mark Scott, Barclays Settles Regulators’ Claims Over Manipulation of Key Rates, N.Y. Times DealBook (June 27, 2012, 8:11 AM), http://dealbook.nytimes.com/2012/06/27/barclays-said-to-settle-regulatory-claims-over-benchmark-manipulation/.

[3] Robert Barr, Bank Scandals Tarnish London’s Reputation, The Miami Herald (Aug. 17, 2012), available at http://www.miamiherald.com/2012/08/07/v-fullstory/2938519/bank-scandals-tarnish-londons.html.

[4] Id.

[5] Id.

[6] See Scott, supra note 1.

[7] Bobbie Johnson, Wonga Readies $1.5bn IPO, but Stigma Won’t Go Away, Gigaom (June 6, 2012, 1:26 AM, http://gigaom.com/europe/wonga-ipo/.

[8] http://www.startups.co.uk/wonga.html.

[9] Scott, supra note 1.

[10] See id.

[11] Id.

[12] See Johnson, supra note 7.

[13] Scott, supra note 1.

[14] John Peabody, GoCardless Tries to Disrupt the Credit Card Industry, Reuters (May 15, 2012), http://blogs.reuters.com/small-business/2012/05/15/gocardless-tries-to-disrupt-the-credit-card-industry/.

[15] Scott, supra note 1.

[16] Id.

[17] Id.

[18] Id.

Private Equity in India

Posted on by Rebecca Targan

Since the enactment of economic reforms in the early 1990s, India has experienced a period of rapid economic growth.[1] On average, GDP has grown over 7% per year since 1997,[2] making India one of the world’s fastest growing economies. In 2004, investors began seeing opportunities for private equity investment,[3] and the market grew from $6.6 billion in 2005 to $55.8 billion in 2007.[4] Despite taking a major hit in response to the economic crisis, investment grew back steadily through early 2011,[5] at which point India had the fastest growing private equity market in Asia.[6] However, towards the end of 2011, investment began trending downward and has languished ever since.[7] Unfortunately, this is due at least in part to the Indian government’s inconsistent policies, which have created regulatory uncertainty among foreign investors.

In January of 2012, the Supreme Court of India held that the Indian government may not tax capital gains from indirect transfers of capital assets located in India, an issue over which there had been much confusion.[8] The suit began after Vodafone, a Netherlands company, had purchased CGP Investments Ltd. (CGP), a company based in the Cayman Islands.[9] CGP’s main asset was an interest in Hutchison Essar Limited (HEL), based in India.[10] Under Section 9 of India’s Income Tax Act, a non-resident must pay tax on income arising through “transfer of a capital asset situate[d] in India.”[11] India’s tax authorities contended that this section applied to Vodafone, claiming that Vodafone’s acquisition of CGP was equivalent to a transfer of shares of HEL to Vodafone. Therefore, the government insisted that Vodafone owed taxes on capital gains derived from the acquisition of HEL.[12] The Supreme Court disagreed, holding that Section 9 did not cover indirect transfers of capital assets situated in India.[13] The case set an important precedent for a number of foreign investors whose deals were structured similarly to Vodafone’s, and provided clarity for others who were hesitant to invest due to the legal uncertainty of the pending case.[14] Unfortunately, the issue was once again opened in March of 2012, thanks to the Indian Financial Minister’s proposal of new tax rules. The proposal would enact General Anti-Avoidance Rules (GAAR),[15] making transactions between international companies with Indian subsidiaries liable for a domestic capital gains tax.[16] GAAR would “effectively overturn[]” the Supreme Court’s decision in the Vodafone case.[17]

The Financial Ministry’s proposal sparked massive uncertainty. GAAR would be retroactive through April 1st, 1962, creating the potential for many cases, including Vodafone’s, to be re-examined.[18] In addition, the outcome of several pending cases regarding M&A deals between international companies that hold Indian subsidiaries is once again uncertain.[19] Moreover, GAAR created further uncertainty among those who might have been planning to invest in Indian companies through deals structured similarly to Vodafone’s.[20] To assuage investor concerns, India’s Prime Minister issued a statement in June of 2012 saying GAAR would not be finalized without his approval.[21] The Prime Minister is expected to soften GAAR’s impact on investors, but exactly how he will do so is still unclear.[22]

The recent actions of the Government of India are problematic for two reasons. First, they re-open the issue of whether the Indian government may tax capital gains from indirect transfers of capital assets situated in India. Hopefully, the Indian government will soon clarify what GAAR’s practical effects will be, and resolve the matter once and for all. Second, even if the Indian Government resolves the GAAR issue in favor of investors, they have now set an example to the world that the law of India is volatile. Private equity deals are carefully structured to gain benefits from whatever legal systems they are subject to, so the fact that India’s laws seem to be constantly in flux is highly discouraging to anyone looking to acquire Indian companies. If the country wants any sort of private equity market, it must find a way to rebuild investors’ confidence in the stability of India’s laws. At any rate, it will not be easy to do so before Indian private equity investment falls even further.

___________________________________

[1] Central Intelligence Agency, Economy: INDIA, The World Factbook, https://www.cia.gov/library/publications/the-world-factbook/geos/in.html#Econ (last visited Oct. 27, 2012). See also T.C.A. Anant & N.L. Mitra, The Role of Law and Legal Institutions in Asian Economic Development: The Case of India 4, 57 (Harvard Institute for International Development 1998).

[2] Central Intelligence Agency, supra note 1.

[3] Malini Goyal, PE: The story of greed, boom and the fall of private equity in India, The Econ. Times (May 17, 2012), http://articles.economictimes.indiatimes.com/2012-05-17/news/31749390_1_pe-firms-pe-investments-subbu-subramaniam.

[4] Deloitte, Private Equity: Fueling India’s Growth 6 (2012), available at http://www.deloitte.com/assets/Dcom-India/Local%20Assets/Documents/Thoughtware/Private%20Equity.pdf.

[5] Id.

[6] Id. at 4.

[7] Id. at 6.

[8] Vodafone International Holdings B.V. v. Union of India & Anr., (2012) __ S.C.R. __ (India), available at http://judis.nic.in/supremecourt/imgs.aspx.

[9] Id. at ¶ 2 (India), available at http://judis.nic.in/supremecourt/imgs.aspx.

[10] Id.

[11] Id. at ¶70.

[12] Id. at ¶ 71.

[13] Id.

[14] Amol Sharma and R. Jai Krishna, Vodafone Overturns Tax Bill in India, Wall St. J. (Jan. 21, 2012), http://online.wsj.com/article/SB10001424052970204616504577172152700710334.html.

[15] 5 Facts About the General Anti-Avoidance Rule (GAAR), NDTV Profit, http://profit.ndtv.com/news/market/article-5-facts-about-the-general-anti-avoidance-rule-gaar-300693 (last updated May 14, 2012, 19:27 (IST)).

[16] James Crabtree, India to Change Tax Law After Vodafone Case, Fin. Times, http://www.ft.com/intl/cms/s/0/d9d96cde-6f59-11e1-9c57-00144feab49a.html#axzz2ASEttu4q (last. updated Mar. 16, 2012 8:32 PM). Language in the amendments seems to be specifically targeted at the Vodafone decision. One of the explanatory notes reads, “[A]n asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India.” Crabtree, supra.

[17] Crabtree, supra note 15.

[18] Crabtree, supra note 15.

[19] Crabtree, supra note 15.

[20] After Vodafone, GAAR; PM Takes Charge of Finance Ministry, The Times of India (June 30, 2012, 2:16 AM IST), http://timesofindia.indiatimes.com/business/india-business/After-Vodafone-GAAR-PM-takes-charge-of-finance-ministry/articleshow/14513903.cms.

[21] Id.

[22] FE Bureau, PM Moves to Soften GAAR, Vodafone Blow, Fin. Express (June 29, 2012, 32:00 IST), http://www.financialexpress.com/news/pm-moves-to-soften-gaar-vodafone-blow/968019/0 See .also FinMin May Amend GAAR Rules to Boost Investor Confidence, Firstpost (Oct. 2, 2012), http://www.firstpost.com/economy/finmin-may-amend-gaar-rules-to-boost-investor-confidence-476521.html

Private Equity Funds in China: Structures, Opportunities and Challenges

Posted on by Chenhao Zhu

Private equity (PE) funds formed to make investments in the People’s Republic of China (PRC) come within three main types of structures. This post identifies and analyzes the characteristics, advantages and disadvantages of each structure, and highlights recent legal developments pertaining to how international investors can build or sponsor an onshore RMB funds.

Introduction

PRC’s economic growth has created a steady flow of investment opportunities. Especially after the global financial crisis, more and more global PE funds seek to deploy capital in this region. The financial crisis turns out to be a starting point for PRC to usher in a completely new phase for its opening-up and become one of the favorite investment destinations. To date, PE industry enjoyed a steady growth as can be seen in the chart below.

chartone

Chart 1 Annual Fundraising Amount by PE Funds focusing on Greater China between 2002 and 2011 Source: Preqin as of 2012

PE funds could be formed in PRC in one of the three structures:

1) offshore US Dollar-denominated funds;

2) onshore domestic-invested RMB-denominated funds;

3) onshore foreign-invested RMB-denominated funds.

Offshore US Dollar-denominated Funds

Offshore US Dollar-denominated funds are formed in non-PRC jurisdictions, most commonly in the Cayman Islands or British Virgin Islands.

Advantages:

· As offshore funds are typically organized as limited partnership, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the availability of pass-through tax treatment, i.e. it avoids dividend tax and double taxation because only owners or investors are taxed on the revenue.

· As offshore funds are organized under laws of Cayman Islands or British Virgin Islands, there are greater certainty and predictability pertaining to the legal enforceability of contracts and limited liability protection of limited partners than entities governed by PRC law.

Disadvantages:

Offshore funds are not governed by PRC law, but their investments made in PRC will be. As they are registered in non-PRC jurisdictions and funded by foreign investors, offshore funds are classified as foreign investors under PRC’s regulatory regime pertaining to foreign investment, and thus are subject to many special restrictions.

According to Foreign Investment Industrial Guidance Catalogue enacted by PRC’s State Council, many sectors and industries are closed to foreign investment. Even for accessible industries, every investment needs government approval. While not difficult to obtain, the great latitude of administrative authorities has generated huge space for rent-seeking. Moreover, the application process can be time-consuming since it involves extensive negotiations with various approval authorities. For example, a large factory may have serious land use or environmental issues. Thus, the exact time frame for approval is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.
· Since offshore funds are denominated in USD yet invest in RMB, government approvals are also required for the conversion of USD into RMB and associated repatriation.

· As there are no PRC tax rules specifically ensuring pass-through tax treatment for offshore funds, investors must be very cautious to make sure that a “permanent establishment” is not created in PRC as the tax exposure of both general partners and limited partners could be adversely affected.

It should be noted that offshore funds used to be able to circumvent the restrictions stated above through “round-trip investment”: typically a PRC national established or controlled an offshore holding company to control a Chinese domestic company by captive contractual arrangement. The Chinese domestic company makes investment in China as a domestic investor while the international investors invest at the offshore level. However, the “round-trip investment” is no longer an easy shortcut as PRC had made significant policy changes in recent years to close related regulatory loopholes.

Since then, more and more PE funds prioritize setting up RMB funds. As can be seen in the graph below, most of the newly-raised funds are denominated in RMB.

charttwo

Chart 2 PRC Private Equity Fundraising. USD Funds vs. RMB Funds, denominated in $US Billons Source: Preqin as of 2012

Onshore Domestic-Invested RMB-Denominated Funds

Onshore domestic-invested RMB-Denominated funds are registered in PRC, comprising exclusively of domestic source of capital. The vast increase in its popularity in recent years could be partially attributed to the corresponding growth of Chinese sources of capital available to onshore RMB funds, including, among others, 1) PRC’s National Social Security Foundation; 2) local government funds held by several provincial and municipal authorities, such as Beijing, Shanghai, Tianjin and Jiangsu; 3) an increasing number of wealthy Chinese entrepreneurs.

It is crucial to note that onshore domestic-invested RMB-Denominated funds are closed to foreign capital, but not to foreign investors. In other words, international investors could sponsor an onshore domestic-invested RMB-Denominated fund as its general partner. First, they should register a management entity in PRC to raise and manage the RMB fund as its general partner. Then, they would raise limited partner capital from domestic Chinese investors. Specific regulations pertaining to such type of transaction vary across provinces and municipalities, as there is not yet a unified set of rules governing investor solicitation and private offering on a national level.

Advantages:

· As onshore funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.

· As onshore funds are classified as “domestic investors” under PRC law, government approval for investment and currency conversion could be avoided, so as the associated lag-time and rent-seeking, resulting in greater efficiency and lower cost.

· As domestic investors, onshore funds can invest in industries restricted to foreigners like television stations and publishing, thus have access to more deals in a broader share of PRC’s economy.

Disadvantages:

· Onshore domestic-invested RMB-Denominated funds are by its nature inaccessible to foreign sources of capital, and thus very difficult to scale their business. As of now, most of them are relatively small in size, with whole funding below US$100 Million.

· Compared to Cayman Island and BritishVirginIsland, there are less certainty and predictability in PRC’s legal matrix, especially pertaining to enforcing contracts in PRC courts. PRC has a lot of capital, but not a large group of seasoned investors. It could be tricky when dispute arise between foreign sponsors and domestic investors, who are unfamiliar with private equity, regarding terms such as capital calls and years-long commitment.

Onshore Foreign-Invested RMB-Denominated Funds

Onshore foreign-invested RMB-Denominated funds are registered in PRC, comprising at least partially of foreign source of capital. They could be organized either as foreign-invested venture capital enterprises (FIVCEs) or foreign-invested limited partnerships (FILPs).

With respect to regulatory framework, of particular importance are the passage of Waishang Touzi Chuanye Touzi Qiye Guanli Guiding (外商投资创业投资企业管理规定) [Administrative Rules on Foreign-Invested Venture Capital Enterprises] (the “FIVCE Rules”) on March 1, 2003, [1] and the Waishang Touzi Hehuo Qiye Dengji Guanli Guiding (外商投资合伙企业登记管理规定) [Administrative Measures on Establishment of Partnership Enterprises by Foreign Enterprises or Individuals in China] (the “FILP Measures”) on March 1, 2010. [2]

According to FIVCE Rules, the scope of investment of FIVCEs is limited to high-tech or new-tech industries. Additionally, FIVCEs are forbidden to make investment by borrowed funds. Thus FIVCE can be a very ineffective model for making PE investment in PRC.

FILPs, as a new investment avenue opened in 2010, offers another promising option for international investors to engage in PE investments in the foreseeable future. The Carlyle-Fosun RMB fund, registered in March 3, 2010, is the first reported FILP. With initial investment of US$100 million, the co-branded fund is a 50/50 joint venture between Carlyle and Fosun, both of which are general partners [3]. Afterwards, Blackstone formed the Shanghai Blackstone Equity Investment Partnership, while TPG launched the TPG Shanghai RMB Fund and the TPG Western China Growth Partners I. Goldman Sachs and Morgan Stanley also reportedly have RMB funds in the pipeline.

Advantages:

· As onshore RMB funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.

· Capital contribution could be made in cash or in kind, subject to valuation and filing requirements.

· Previously, PE investments by foreign investments are subject to approval of Ministry of Commerce (MOFCOM), which could be very intrusive, paper-intensive and time-consuming. But according to FILP Measures, FILPs could be set up by registration with State Administration of Industry and Commerce only, thus bypassing the burdensome process of MOFCOM approval.

· It could use RMB to invest more easily in domestic companies in PRC, thus help take them public in PRC, on the Shanghai or Shenzhen stock markets. By contrast, offshore USD funds typically made investment into companies that were structured for a public listing outside PRC. Since IPO valuations are at least twice as high in PRC as they are in Hong Kong or USA, investment through RMB funds leading to a Chinese IPO can earn foreign investors a much higher return, likely over 300% higher, than otherwise.

Disadvantages:

· When organized as offshore funds governed by Cayman law, the general partner and the fund manager are typically exempted from taxation. But as the general partner and the fund manager of FILP are treated as PRC tax resident, the carried interest and management fee payments are taxed at the PRC corporate income tax rate at 25%.

· FILPs are still subject to the previously mentioned Foreign Investment Industry Guidance Catalogue, thus could not invest in industries restricted to foreigners like television stations and publishing.

· The local limited partners may not be as sophisticated as the international investors. Their lack of experience and unrealistic expectation of high yields may possibly damage the business cooperation.

Recent Regulatory Developments

In 2011, the four direct-controlled municipalities of PRC: Beijing [4], Shanghai[5] , Tianjin [6] and Chongqing [7], initiated significant pilot programs as to RMB funds organized as FILP. Under these programs, certain FILP could avoid more regulatory hurdles. For example, foreign capital contribution by foreign general partners and qualified limited partners may not be subject tot foreign currency conversion approval.

Indeed PRC is taking cautious steps to further open up its PE market. On November 23, 2011, PRC’s National Development and Reform Committee (NDRC) promulgated the first nationwide regulation of PE industry: Guojia Fazhan Gaigewei Bangongting Guanyu Cujin Guquan Touzi Qiye Guifan Fazhan De Tongzhi (国家发展改革委办公厅关于促进股权投资企业规范发展的通知) [The Notice on Promoting the Standardized Development of Equity Investment Enterprises]. [8] On one hand, it tightens regulation of PE funds by requiring that all the PE funds shall register with NDRC or its counterparts at provincial level. On the other hand, the notice further opens PRC’s PE market to international participation as it does not reverse or limit any of the pilot programs’ initiatives to circumvent the foreign current regulations. In other words, this state-level regulation’s “hands-off” approach implicitly encourages local authorities to offer new incentives to attract international capital, and implicitly encourages international investors to continue forum shopping among these competing programs.

Summary

To sum up, the PE industry in PRC is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. With respect to investment avenues, the advantages of onshore RMB funds are clear: they can make investment without foreign exchange controls, they face much less red tape and they can raise funds from PRC’s local sources. Carlyle, TPG and Blackstone, as the earliest market entrants in this regard, have each launched their own RMB funds in partnership with leading PRC private company, and point the way forward for many of its peers in US. As PRC authorities gradually opens up its PE market to foreign capital, an increasing number of PRC’s strong private enterprises will get growth capital from international PE investors with the know-how and pools of RMB to build great public companies.

_____________________________________
*Chenhao Zhu received a JSM (Master of Science of Law) from Stanford University in 2011, where he was the recipient of Franklin Family Fellowship and an editor of Stanford Journal of International Law. He is now an associate in the Palo Alto office of K&L Gates LLP, focusing on US-China business transactions, especially venture capital and private equity investments.

[1] Promulgated by the Ministry of Commerce (formerly, Ministry of Foreign Trade and Economic Cooperation), Ministry of Science and Technology, State Administration of Industry and Commerce, State Administration of Taxation and State Administration of Foreign Exchange on Jan. 30, 2003, effective on Mar. 1, 2003.

[2] Promulgated by the State Administration of Industry and Commerce on Jan. 29, 2010, effective on Mar. 1, 2010.

[3] See Shanghai Approves Carlyle and Fosun Joint RMB Fund; First Business License Granted to Foreign-Funded Equity Investment Partnership Enterprise. http://thecarlylegroup.com/news-room/news-release-archive/shanghai-approves-carlyle-and-fosun-joint-rmb-fund-first-business-license- (last visited Oct. 13, 2012)

[4] See Beijing Shi Guanyu Benshi Kaizhan Guquan Touzi Jijin Jiqi Guanli Qiye Zuohao Liyong Waizi Gongzuo Shidian De Zanxing Banfa (北京市关于本市开展股权投资基金及其管理企业做好利用外资工作试点的暂行办法) [Interim Measure on Pilot Program of Utilization of Foreign Capital By Equity Investment Fund and Its Management Entity of Beijing Municipality] (promulgated by Beijing Bureau of Finance, Beijing Commission of Commerce and Beijing Administration of Industry and Commerce on Feb. 28, 2011, effective on Feb. 28, 2011).

[5] See Shangha Shi Guanyu Benshi Kaizhan Waishang Touzi Guquan Touzi Qiye Shidian Glongzuo De Shishi Banfa (上海市关于本市开展外商投资股权投资企业试点工作的实施办法) [Implementation Measures for Foreign-Invested Equity Investment Enterprises Pilot Programs of Shanghai Municipality] (promulgated by Shanghai Financial Service Office, Shanghai Commission of Commerce and Shanghai Administration of Industry and Commerce on Dec. 24, 2010, effective on Jan. 23, 2011.

[6] See Tianjin Shi Guanyu Benshi Kaizhan Waishang Touzi Guquan Touzi Qiye Jiqi Guanli Jigou Shidian Gongzuo De Zanxing Banfa (天津市关于本市开展外商投资股权投资企业及其管理机构试点工作的暂行办法) [Interim Measure on Pilot Program of Foreign-Invested Equity Investment Enterprises and Its Management Entity of Tianjin Municipality] (jointly promulgated by Tianjin Development and Reform Committee, Tianjin Financial Service Office, Tianjin Commission of Commerce and Tianjin Administration of Industry and Commerce on Oct. 14, 2011, effectively on Dec. 13, 2011.

[7] See Chongqing Shi Guanyu Kaizhan Waishang Touzi Guquan Touzi Qiye Shidian Gongzuo De Yijian (重庆市关于开展外商投资股权投资企业试点工作的意见) [Implementation Measures for Foreign-Invested Equity Investment Enterprises Pilot Programs of Chongqing Municipality] (promulgated by Chongqing Administration of Industry and Commerce, Chongqing Foreign Economics and Trade Commission and Chongqing Office of Finance on Mar. 31, 2011, effectively on Mar. 31, 2011.

[8] Promulgated by the Office of Staff of National Development and Reform Commission on Nov. 23, 2011, effectively on Nov. 23, 2011.

Presidential Politics and Private Equity

Posted on by Todd Bullion

This election season there has been a good deal of discussion over Mitt Romney’s time spent at Bain Capital. The Romney Campaign has sought to highlight that experience as a qualification to lead the country to a better economic future. The Obama Campaign and other groups affiliated with it have made the argument that Romney eliminated and outsourced jobs during his time at Bain Capital. [1]

Concerns exist that this election could bring increased public attention to the Private Equity industry, and give politicians extra incentive to regulate the industry. [2] In a recent survey of Tech Industry executives, where the Tech executives were questioned on the Presidential election, “78% say that the campaign’s focus on Romney’s roots in private equity have “damaged” the reputation of private equity and venture capital”; [3] and, “65% worry that there could be new regulation of private equity and venture capital investing”. [4] However, there is little reason to be concerned that the election will give politicians an impetus to further regulate the private equity industry.

There is evidence that political advertisements based on Romney’s Bain record have been effective; a Super PAC running political advertisements attacking Romney’s Bain record claim that their internal polling shows that “a decisive plurality of voters said Mitt Romney’s record as Bain CEO makes them less likely to vote for him.”[5] These advertisements highlight negative consequences of pursuing a strategy of profit maximization with a special focus on outsourcing, downsizing, and reducing employee benefits.[6]

However, the persuasive thrust of these advertisements could be effectively applied to all profit-maximizing business, particularly large businesses. In a recent PEW Research poll over 50% of respondents said businesses make too much profit. [7] In the same poll slightly less than 50% of respondents said that Wall Street hurts the economy more than it helps it. [8] And perhaps most significant, 67% of respondents claimed that Wall Street only cares about making money for themselves. [9]

It is a well-known fact that manufacturing companies pursue strategies of profit maximization as a rule of thumb. To maximize profits manufacturing companies have outsourced jobs, downsized workforces and when possible reduced employee benefits. However, manufacturing companies are not facing the same negative press as private equity firms. Consider for a moment that instead of working at Bain Capital Mitt Romney had become the CEO of General Motors. I suspect in this hypothetical world where Mr. Romney was CEO of General Motors – never having worked in private equity – we would see almost all of the same political advertisements currently on the air criticizing Mr. Romney’s Bain record, but with the word’s GM in place of Bain Capital.

In short, I posit that the public does not hold a special grudge for the private equity industry. That while the election may have certainly put private equity in the spotlight nothing of consequence will come from it because criticisms of the private equity industry are both general in nature and very similar to criticisms made of profit maximizing institutions in general. Consequently, concerns that new private equity or venture capital regulations may be coming as a result of the Presidential election are likely overblown.

[1] See , Michael Shear, A Final Push in Swing States, in a Bid to Break the Stalemate, N.Y. Times (Oct. 23, 2012) http://www.nytimes.com/2012/10/24/us/politics/a-tight-focus-on-battleground-states-as-campaigning-time-dwindles.html (describing Priorities USA plan to spend several million dollars on adds that tell the stories of people who lost their jobs after Bain Capital acquired the companies which employed them).

[2] Eric Savitz, Tech Execs Mostly Back Romney, But Expect Obama to Win, Forbes (Oct. 8, 2012, 8:04 PM) http://www.forbes.com/sites/ericsavitz/2012/10/08/tech-execs-mostly-back-romney-but-expect-obama-to-win/

[3] Id.

[4] Id .

[5] Alex Pappas, Democratic Super PAC to Revive Attacks on Romney’s Bain Record, The Daily Caller (Oct. 20, 2012, 9:41 AM) http://dailycaller.com/2012/10/20/democratic-super-pac-to-revive-attacks-on-romneys-bain-record/

[6] Shear, supra note 1.

[7] ‘Staunch Conservatives’ Are Warry of Wall Street , Pew Research Center (May 26, 2011) http://pewresearch.org/pubs/2003/poll-wall-street-business-financial-crisis

[8] Id .

[9] Id .